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QEII? Fed eyes looser monetary policy

By Robin Harding in Washington
Published: July 19 2010 19:20 | Last updated: July 19 2010 19:20

A slew of weak economic data means that when Federal Reserve chairman Ben Bernanke gives his semi-annual testimony to Congress Wednesday his job will be to reassure.

That reassurance might come in three forms: first, that the Fed thinks the economic recovery is still on track; second, that the central bank is ready to act if the economy does falter; and third, that the Fed is confident it has the tools to avert both inflation and deflation if it needs to.

In spite of slow growth in jobs – private payrolls rose only 33,000 in May and 83,000 in June – the Fed’s basic outlook is still one of steady recovery.

Most members of its rate-setting open market committee forecast growth of 3-3.5 per cent this year and higher next year. They forecast core inflation of 0.8-1 per cent.

“I’m expecting growth to continue,” says Jeffrey Lacker, president of the Richmond Fed, in an interview with the Financial Times.

“It’s important to remember as well that the economy’s still expanding despite the slightly disappointing data we’ve seen in the last few weeks.”

That outlook means the Fed is still a long way from changing its policy – something Mr Bernanke is likely to make clear in his testimony.

What the bad data do prompt is a reversal in the Fed’s internal debate: in spring it was all about when and how to exit from very loose monetary policy, now it is more about what to do if even looser policy were required.

Fed officials have a range of measures to judge if the outlook has deteriorated far enough to merit more easing. Some are focused on inflation expectations, which remain quite strong. As long as consumers, markets and businesses still expect inflation, these officials are fairly confident that it will come to pass.

Others will need evidence that the recovery is no longer on course to bring down unemployment.

If weak job market data continue, for example, they could prompt concern about downward pressure on wages leading to very low inflation.

The Fed identifies a range of options if it does need to act but all of them come with risks, opponents on the Federal Open Market Committee, and uncertainty about their effects. The two simplest measures will be to stop paying interest on bank reserves, encouraging banks to lend the money out instead, or to start reinvesting capital repayments from the Fed’s portfolio of mortgage-backed securities.

Neither is a drastic move but the Fed will expect quite a strong signalling effect from its first change towards looser policy.

Cutting interest on bank reserves has the advantage of being easy to reverse but could lead to serious distortions in the money markets.

Another possibility is a change of communication. One option that the Fed has begun to study is linking its pledge of low rates to an external condition.

At the moment, the Fed says rates are likely to stay “exceptionally low” for an “extended period”. Instead, it could say that they will stay low until a variable, such as the price level, has reached a certain target.

Academic research suggests this could be effective in preventing deflation because it commits the central bank to keeping rates at zero until the goal is reached. It would not distort markets and is more flexible than a crude promise to keep rates at zero for a fixed period.

Markets already expect the Fed to keep rates on hold until well into next year, however, which limits the potential gains. FOMC hawks such as Thomas Hoenig, the Kansas City Fed president, who already oppose the “extended period” language, will be deeply reluctant to tie their own hands in this way.

The second option – to start expanding the Fed’s balance sheet by buying more Treasuries or asset-backed securities – is the most controversial. Most Fed officials think that asset purchases were quite effective when the threat came from financial market turmoil early in 2009. They are less sure of the effects when markets are calm.

Many FOMC members are also seriously concerned about the side-effects of buying more assets.

“I would want to be convinced that the incremental macroeconomic benefits outweighed any costs owing to erosion of market functioning, perceptions of monetising indebtedness, crowding-out of private buyers, or loss of central bank credibility,” Kevin Warsh, a Fed governor, said in a speech.

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